Tuesday, 13 October 2015

Discounted Cash Flow by Matthew Roddan

. Do you know stock market
speculations are based on DCF? Whether it is acqui When a company’s financials
are scrutinized, metrics used to evaluate the same are important. According to
Wall Street, a company’s cash flow is the best indicator for a company’s
performance. As such, DCF or discounted cash flow analysis is used to determine
a company’s worth by estimating future cash flows.

Projected cash flows (operating
profit + depreciation + amortization of goodwill - capital expenses - cash
taxes - alteration in working capital) are discounted to current value using
company’s weighted average costs. In short, DCF is an effective and
unparalleled tool for determining share value, which is important for
investors.

Also, a few financial scandals only
hiked the importance of DCF. With more concerns about reliability of earnings
and calculation of P/E or cash flow determination, coming up with a DCF model
calls for more efforts than merely dividing share price by income or sales.
However, taking this effort ensures investors get a good idea of the key
factors like share value, projection of future income or profits, growth ratio,
etc. Besides, DCF can’t be manipulated through aggressive accounting practices
easily.

While DCF is a very useful tool, it
isn’t without shortcomings. It is a mechanical valuation tool that works akin
to garbage in, garbage out saying. So, any minor change or change in
assumptions could lead to major differences. But, investors should always
crosscheck evaluations and allow considerable margin for such changes or
errors, when taking decisions. Major investment decisions should not be taken
purely relying on DCF calculations alone. What if a client backs off from a
contract, or what if interest rates hike unexpectedly or even a competitor
cropping up with crushing prices and the firm losing most business? Remember,
when expectations change, calculations or derivations based on the assumptions
will change along with it! Do you know even reputed investor Warren Buffet and
other financial experts and portfolio managers rely on DCF?

Discounting cash flow is tricky and
it is important to remember that assuming or predicting future estimates could
be meaningful or meaningless depending on the estimates taken and how
reasonable they are. Besides, numbers aren’t static and keep changing with
changing trends. As for investors, evaluating stock pricing is very important
and DCF is a handy aid for calculating the same, says Matthew Roddan of Project Ninety Ninering a
business, or a property, or investing on stock, DCF helps with speculating
approximately.